Two Cheers for Ben

I admit that I have not been kind to Ben Bernanke. And although I have never met him, he seems like a very nice man, and I think that I would probably like Mr. Bernanke if I knew him. So, aside from my pleasure at seeing a concrete step taken toward recovery, I am happy to be able to say something nice about Mr. Bernanke for a change. And it’s not just me, obviously the stock market has also been pleased by Mr. Bernanke’s performance of late, and especially today.

Almost three months ago, I wrote a post in which I complained when the FOMC in its statement described a weakening economic recovery and falling inflation, already less than the Fed’s target, with no sense of urgency about improving the economic situation and ensuring that inflation would not continually fail to reach even the stingy and inadequate target that the Fed had set for itself. A few days later, I voiced alarm that inflation expectations were falling rapidly, suggesting the risk of another financial crisis. The crisis did not come to pass, and Bernanke’s opaque ambiguity about policy, combined with an explicit acknowledgment of a weakening economy, provided some Fed watchers with grounds for hope that the Fed might be considering a change in policy. But in his testimony to Congress in July, Bernanke declined to offer any reassurance that a change of policy was in the offing, a wasted opportunity that I strongly criticized. However, in its August meeting, the FOMC finally gave a clear signal that it was dissatisfied with the current situation, and would take steps to change the policy in September unless clear signs of a strengthening recovery emerged that would indicate that no change of policy was necessary to get a recovery started. By late July and early August, the perception that the Fed was moving toward a change in policy led to a mini-rally even before the August FOMC meeting.

Thus, the entire summer can be viewed as a gradual build up to today’s announcement. From early July until today, inflation expectations, as approximated by the 10-year breakeven spread between 10-year Treasuries and 10-year TIPS, have been gradually rising as have stock prices. And today, the 10-year breakeven spread increased by 11 basis points, while the S&P 500 rose by almost 2%, the gains coming almost entirely after release of the FOMC statement shortly after 12PM this afternoon. Since early July, the 10-year breakeven spread has increased by 38 basis points, and the S&P 500 has risen by 9%.

The accompanying chart tracks the 10-year breakeven TIPS spread and the S&P 500 between July 12 and September 13 (both series normalized to be 100 on July 12). The correlation coefficient between the two series is 92.5%.

To provide a bit more perspective on what the increase in stock prices means, let me also note that today’s close of the S&P 500 was 1459.99. That is still about 100 points below the all-time high of the S&P 500, reached almost 5 years ago in October 2007. If the S&P 500 had increased modestly at about a 5% annual rate, the S&P 500 would now be in the neighborhood of 2000, so the S&P 500, even after more than doubling since it bottomed out in March 2009, may be less than 75% of the level it would be at if the economy were performing near capacity. To suggest that the S&P 500 is now overvalued – just another bubble — as critics of further QE have asserted, doesn’t seem even remotely reasonable.

So Mr. Bernanke had a very good day today. Let’s hope it’s the start of a trend of good decision-making, and not just a fluke.

The S&P500 was over-valued in October 2007 – as it was in August 2000 – because earning were top-of-the-channel high, inflation was low, and investors were overly optimistic about future cash flows from stocks.

Today’s S&P price is below the August 2000 level, so my assertion that investors miscalculated future cash flows from stocks in 2000 looks pretty solid after 12 years. October 2007 is not as far back in time, so future cash flows could catch up to Oct 2007 expectations, but that seems unlikely.

If future earning and dividends follow the historical paradigm, the market is moderately over-valued. Perhaps the Fed changed the game today and set the S&P on a new course which requires new valuation calculations. Time will tell. But comparing today’s S&P price to Oct. 2007 to determine fair value is not a good idea.

The key question is whether the Fed’s actions keep corporate earnings at or above the top of the historical earnings channel. If that happens, then stock valuations can and should go up from here. If corporate earnings return to the historical channel despite the Fed’s actions, then the current over-valuation will be corrected.

I’m happy with this too. I look at ti this way-the only people who don’t seem to like this is Romney, Donald Trump-who claimed on CNBC that QE overly benefits the rich!-and now the ratings agency Eagan-Jones that absurdly just lowered our credit rating.

There are some who argue about how effective it is but I’ll fall back on the saying that there are no athesits in foxholes.

Bernanke actually talked about how joblessness is a problem taht should worry all Americans and that he’ll do whatever it takes within his power.

He may be an unelected bureaucrat but I’d elect him today if he ran for soemthing.

Marcus, You may well be right. We shall see. Market enthusiasm seems to be on the wane this week.

KH, The S&P 500 in October 2007 was overvalue relative to the actual course of events that followed, but that doesn’t mean that that was the only possible course of events. In an alternative, but possible, world the realized cash flows might well have justified the implicit valuations in October 2007, just as an alternative, but possible, world might have justified the implicit valuations in October 1929. I agree that we take the valuations in October 2007 and just extrapolate forward to infer the appropriate level of stock prices today. I only meant that as an exercise to estimate the potential upside of stock prices if we were to see a strong recovery.

Ritwik, Yes he very well may make a bad decision, and smart investors should be taking that into consideration in valuing stocks right now.

Mike, Martin Wolf had an excellent piece in today’s Financial Times that made a similar point.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.